Chapter 2 - Valuation and liquidity issues for start-up companies

2.1 During the course of further consultation on the detail of the proposals contained in the May 2016 issues paper, submitters raised concerns that the general proposals did not address the valuation and liquidity issues faced by start-up companies offering ESS benefits.

2.2 In particular, if the tax from receiving an ESS benefit arises without a sale or an active market for the shares, and where there may be little or no earnings history or realisable assets, it is difficult to determine the shares’ value so as to work out the tax liability. Even if the shares can be valued, the employees are often unable to sell a portion of their shares to meet the tax liability and therefore have to fund the liability from other income or borrowings – thus making the scheme less attractive. The employer could provide cash income to pay the tax. However, start-up companies typically experience cashflow constraints as well and therefore the problem is simply transferred to the employer.


2.3 Under both the current law and the proposals in the Bill, calculating the tax payable by an employee often requires a valuation of the shares at the relevant taxing point.

2.4 If the shares are in a listed company, the value of the shares at the time tax is payable can be easily found. It is more difficult to determine the value of the shares in an unlisted company, particularly if it is an early stage or start-up company, with little or no operating history, no cashflows and very few tangible assets. For example, the value of such a company may depend completely on its success in developing an untested idea, and as such is extremely speculative. In such a case, determining the value of the shares is an uncertain and difficult exercise, as well as a potentially expensive one.

2.5 Inland Revenue has recently introduced valuation guidelines for shares received by an employee under an ESS.[4]


2.6 Start-up companies are also often cash constrained – all available cash is allocated to developing the business. This is one reason they use employee share schemes to remunerate employees – because it reduces the amount of cash salary they have to pay. Similarly, an employee who accepts part of their remuneration in shares may not have a lot of extra cash. They may receive a modest cash salary to cover living costs and the rest of their remuneration in shares.

2.7 Compounding this issue is that in early-stage companies, and often in a broader set of unlisted companies, there is a very limited market for the employee’s shares. The employee will also often be prohibited from selling the shares other than to existing shareholders (and in some cases, that also may be impermissible) by the terms of the scheme. However, there will usually be no requirement for the existing shareholders to buy the shares. This makes it very difficult for the employee to sell their shares.

2.8 Because the shares may not be easily sold to generate cash, submitters have raised the imposition of tax on the ESS benefit received as a barrier to using ESS. Under current law, subject to the potential application of the general anti-avoidance rule, it has been possible to provide share benefits to employees without any income tax arising. So in many cases, this practical cashflow issue may not have been relevant because there is simply no tax to pay. The proposed measures in the Bill prevent the use of these structures to avoid tax. While this is the correct economic outcome, officials recognise the case for considering ways to reduce the difficulty of meeting a tax cost from receipt of illiquid shares.

Self-help solution – long-term options

2.9 Under current law, it is possible to legitimately structure an employee share scheme so that it has the practical effect of deferring the taxing point – thus avoiding or minimising issues of liquidity and valuation. This can be done by using what is known as a long-dated option.

2.10 For example, if an employee is given an option which expires in 20 years, the employee can defer the taxing point in relation to that option until the company has an initial public offering (IPO) or the employee wishes to sell the shares. The employee can wait until that time to exercise the option. The employee will then have income equal to the value of the shares at that time, less the option price. This avenue for avoiding cashflow and liquidity issues is not affected by the Bill.

2.11 However, submitters have said that option holders may not have the same sense of ownership as shareholders. Option holders do not ordinarily have certain rights held by shareholders in a company, including the right to vote. Share ownership is desirable as it aligns the employees’ motivations with the company’s.

2.12 Submitters also explained that long-dated options are undesirable from the perspective of other shareholders and may result in a significant accounting expense for employers that have to comply with IFRS.

2.13 Therefore submitters said that, as a practical matter, many companies may not wish to take advantage of this self-help solution.


4 Commissioner’s Statement CS 17/01 – Determining “value” of shares received by an employee under a share purchase agreement.